Strong jobs report could spur rate climb

Good news on the job front isn’t necessarily good news for the direction of interest rates. One Wall Street firm says the long-expected rise in long-term U.S. government bonds “has probably just begun.”

For most of the year, the 10-year Treasury note has defied Wall Street’s early-year prediction of rising rates. The 10-year note ended 2013 at 3.03% and economists expected the rate to spike higher on the expectation of an improving U.S. economy. But that market call soured when the economy got socked by a blustery winter, which caused growth to contract 2.9% in the first quarter, causing money to pour back into bonds. On May 28, the 10-year note hit a 2014 low of 2.44%.

But that all changed this week with back-to-back better-than-expected readings on job creation in June. On Wednesday, payroll processor ADP said private employers added 281,000 jobs last month, topping analyst estimates by 76,000. Thursday, the government reported job gains of 288,000 in June — way above what was expected — and a drop in the unemployment rate to 6.1%, a post-financial crisis low.

Rates spiked sharply on the news. By the end of trading Thursday, the 10-year note was yielding 2.65% — a two-month high — up from 2.52 on Monday, the final day of June.

In the chart below, supplied by Yahoo Finance, you can see the sharp rise in the yield on the 10-year note this week:

Low rates, of course, have been a key driver of the bull run in stocks the past five years. So Wall Street is closely watching how the stock market reacts to the threat of an earlier move by the Federal Reserve.

Part of the rise in long-term yields reflected a growing belief that the Fed will likely have to start hiking short-term rates earlier than the middle of next year as expected in an effort to avoid the consequences of keeping rates too low for too long. Capital Economics, for example, revised its rate-hike timetable Thursday. It now expects the first rate hike to come in March, roughly three months ahead of schedule.

This week’s jump in rates is likely the start of the move to higher longer-term rates, John Higgins, an economist at Capital Economics, warned clients in a research report.

“If history is any guide, it won’t be long before the 10-year yield begins to climb in earnest ahead of a first rate hike that we expect in the spring,” Higgins wrote.

There have been seven major Fed tightening cycles since the early 1970s, Higgins says. And his research found that “in all seven cases the trough in the 10-year Treasury yield occurred well before the first (Fed) rate increase — on average seven months before. The average upward move in the 10-year note’s yield from its pre-rate-hike low to the actual hike was 1.1 percentage point.

“So, if history is a useful guide, it would not be surprising if the 10-year yield started to rise steadily soon,” Higgins said, adding that his firm expects the 10-year will end 2014 at 3%.